The stock market and economy of the country are interrelated. People think that if the stock market is showing a downtrend, then the economy also shows a downtrend. But there is no strong evidence to prove this. Rather the stock market show what investors believe is the state of a country’s economy. So realize that the index of the stock market is just a price which fluctuates according to the demand and supply theory.
The basic rule in economics states that if the supply increases, the price automatically decreases. For instance, if the manufacturing of the automobiles has increased, then the prices of automobiles are sure to decrease. When we apply the same theory to the stock market, as the company increases its stocks, the price of the stock should decline. And, if the stock prices decline, then the economy should fall. But this is not seen in the economy and added to this the new stocks are issued when the economy is growing. This is mainly because when a company makes money from the stock market, it uses that money to grow its business. Hence, the economy grows.
The inherent value is used to evaluate the stocks and this influences the investors to sell or buy stocks. The inherent value is determined by the total expected earnings which a company makes in a specific. It is based on the reality that the value of the dollar tomorrow will not have the same value that is has today. If the investors start believing that it is time for recession, they will think that the earnings of the company will reduce. This reduces the inherent value and the stocks are sold. And this leads to downtrend in the market.
The relation between the stock market and the economy is not logical. In the general terms if the Y happened before Z, we think that Y caused Z. The stock prices fall because the investors think that the economy may fall and therefore, sell the stocks. So it is not the economy which is affecting the stock prices or the stock prices that is affecting the economy, it is the thinking of investors which is affecting the indices most of the times.
Investors usually depend on the macroeconomic situations to buy or sell the stocks. And the investors are right about the downtrend of the economy. But they apply this strategy in stock market before there is any visible downtrend in the economy. And, this makes people think that recession is caused due to the market.